GDP is a measure of the value of a country’s overall economic output or national income in terms of output. It can also be defined as “the market value of all final goods and services made within the borders of a country in a year.”

One objection that people have is that GDP is “fake” because it supposedly measures “consumption on imported products as national income.” But these people are actually clueless about what GDP actually is. In fact, by definition, the value of imported goods in the trade deficit is subtracted from GDP whether they were bought in consumption, investment or by government spending, and the resulting measure of GDP leaves us with the value of all domestic goods and services. Thus GDP is national income minus imports in the trade deficit. The value of the remaining imports is paid for by earnings on exports, so one can hardly complain that this is based on debt.

Now to the idea that GDP is “meaningless.” If this were really the case, then an immediate consequence is the components of GDP are also meaningless.

We can start with exports minus imports. Does the total value of UK exports “lack any significance” or have “no use”? The earnings from exports are a fundamental source of income through foreign exchange for a country. The total value of money spent on imports also shows how much a country is consuming from overseas. And are we to say that establishing whether or not a country has a trade deficit or surplus (i.e., exports – imports) “lacks any significance”? Clearly it does not. It is a fundamental measure of trade balance. People who regard current account deficits as a form of “living beyond one’s means” are clearly directly dependent on a major component of GDP to establish whether a country has a trade deficit or not. Such people cannot claim that a country is “living beyond its means” and then claim that the trade balance component of GPD is a meaningless measure because they are dependent on it themselves. Without it, they would have no justification whatsoever for their view, as they would have no knowledge at all of whether the country is in trade balance or not.

Next, let’s look at gross investment. Although gross investment includes spending on housing, it excludes spending on financial assets or financial instruments. Thus by definition it excludes the second major type of economic activity that causes debt-fuelled bubble growth. Although much housing is funded with debt, it at least provides a real asset that is of use to the community that can be resold as a benefit to other people. That overinvestment in housing through debt was a major factor in distorting economies over the last 20 years is undeniable. But, with orderly deleveraging and a proper correction in prices, the houses themselves are real assets that will make the community wealthier, not poorer. There is no sense in which the housing construction component of GDP “lacks any significance.” It might have been funded by excessive private debt, but this is saying something quite different from the former statement about GDP. Moreover, gross investment also includes replacement purchases, net additions to capital assets and investments in inventories. Thus gross investment includes new spending in capital goods, production facilities and factories. These are fundamental parts of the productive sector of the economy allowing it to engage in production. The belief that a measure of this “lacks any meaning” is utterly absurd. It can tell you a great deal about how much investment there is in real productive capacity in an economy (one criticism of gross investment is that it does not take account of the cost of depreciation. But this limitation is well known, and hardly makes the measure “without significance or value”).

Private consumption is the total value of private household final consumption expenditure, including durable goods, non-durable goods, and services. But it also excludes home purchases. It is here that critics complain that GDP is meaningless, because over the past two decades an increasing part of it has been financed by private debt. On the contrary, a measure of the value of private consumption allows us to calculate the extent to which consumption is being increased by private debt. Far from being meaningless or without significance, this is a crucial indicator of the health of the economy. Excessive private debt is a serious problem, but you can only know how serious by calculating GDP and looking at the annual increase in private debt. One can complain that consumption is excessive because of too much private debt, but this does not make the total value of private consumption “meaningless.” It obviously has a great deal of significance.

Lastly, we come to government spending. This is the component of GDP that anti-government advocates of free markets object to. Their objections are usually justified with the a priori belief that government spending is never productive or beneficial. However, if you reject their a priori premise that government is bad, then there is no reason why government spending should not be included in GDP. Government provides fundamental things like basic R&D for science, education, health care, and public infrastructure – all things of use to the community. For example, our public infrastructure and transportation systems are the foundation of economic life.

The second argument against counting government spending in GDP is that sometimes it is based on public debt. This commits the fallacy of equating public debt with private debt. But public debt is wholly different from private sector debt, for these reasons:

(1) the government is the monopoly issuer of its own currency; no private individual can print money;

(2) if necessary, the government can monetise its deficit;

(3) the government has the power to rollover much of its debt, unlike private individuals;

(4) the government’s central bank has the power to buy back bonds with new money and to control interest rates and bond yields if necessary, and

(5) the government has access to tax receipts which grow over time and with economic growth.

Clearly, the belief that government debt is like household debt is utterly false. It may be a “common sense” and “intuitive” idea for many people, but this is no convincing argument in its favour. For many people over the centuries, the idea that the sun revolves around the earth was a “common sense” and “intuitive” belief. But that “belief” couldn’t be more wrong. The same thing applies to the belief that governments are like private households.

Consequently, the government spending component of GDP is meaningful.

On the other hand, there are legitimate criticisms of GDP that can be made. For example, that GDP takes no account of inequality of wealth and does not measure unpaid work. In developing countries where monetary exchanges are much less significant (e.g., where barter still has a place), GDP underestimates economic activity. In cases where economic activity involves repairing damage or rebuilding after some destructive event like a natural disaster or war, GDP is boosted in a way that can be misleading. Yet another problem is that GDP neglects negative externalities, or the harmful effects of economic transactions that are not reflected in the price.

All these criticisms of GDP, however, tend to recognise that it does convey useful information, although there may be limits to how much can be learned from the measure. This is a far cry from the absurd claim that GDP has no meaning.

Appendix 1: Other Confusions about GDP

Reviewing some of the comments on the Cynicus Economicus blog, one finds other confusions about GDP. I list these comments below with responses.

as Cynicus has previously stated GDP is no longer a measure of productivity, but it is a measure of consumption, most of which is via debt spending in shops and by companies.

GDP does not measure productivity. GDP measures the value of output, or national income in terms of output, as some prefer to say. You measure productivity by productivity indices.
Moreover, GDP includes a measure of gross investment (e.g., fixed capital investment), takes account of earnings from exports, and a good deal of government spending in R&D and education can be considered as investment as well. It is not possible to say that GDP is just “a measure of consumption.” Although consumption is clearly part of it, much of this consumption is also national income, spent on domestically-produced goods and services.

and you fail to acknowledge that consumer debt spending on imported goods is also measured in GDP of national income when clearly it is not.

This is false. As I have noted above, GDP is national income in terms of domestic goods and services, and by definition all imported goods in the trade deficit are subtracted from GDP whether they were bought in consumption, investment or by government spending.

Appendix 2: Total US Domestic Spending and Investment Minus Total Imports

As noted above, GDP subtracts the value of the trade deficit. The means to pay for imports not part of the trade deficit come from earnings from exports.

But one can also calculate the value of total US domestic public and private spending and investment minus total imports (= TDSI). To do this we would remove the value of exports from the calculation of GDP as below:

Therefore total US domestic public and private spending and investment minus total imports is as follows:

14.6349 – 1.946 = $12.6889.

Therefore the total value of all US domestic spending and investment minus total imports was $12.6889 trillion.

This means that 88.98% of US GDP was actually private or public spending or investment on US domestic goods and services. That means that the vast majority of GDP was not due to imports at all.

If you seriously believe that GDP is a “worthless” measure because it includes consumption of foreign imports, then it is not difficult to calculate that the actual size of the US economy once imports are subtracted is $12.6889 trillion.

15 comments:

When you replied to my comment on CE's blog you quoted me as saying that "One of the common themes of this blog is that GDP is meaningless". You omitted the rest of the sentence " - over the short term anyway". Are you sure you haven't devoted an entire post to demolishing a non-existent argument?

The way I see it, GDP varies to a large degree with the derivative of the country's borrowing, and there is no way of knowing whether that component of GDP is 'real' or just economic froth that will disappear when the borrowing turns down. Looking around Britain, at the number of 'economically inactive' people, the sub-literate and sub-numerate university entrants, the road sweepers who drive Lexuses paid for by borrowing against their house etc. it is hard not to conclude that something has gone wrong somewhere along the way, and that once the borrowing stops, the true size of the economy will be revealed to be much smaller.

So yes, 'austerity' will reduce GDP; it is a statement of the obvious. Yes, it will make the debt-to-GDP ratio worse; that is the corollary of increasing borrowing having not made it worse previously!

This post is also a response to the commentator “George,” as well as you.

You say:

You omitted the rest of the sentence - "over the short term anyway"

I think it is clear that even over the short term GDP is not “meaningless.”Earnings from exports do not involve any rise in debt in your country.

And investments in fixed capital goods are productive investments, so the fact that some of them are financed by debt seems irrelevant: this is how capitalism has always worked.

The way I see it, GDP varies to a large degree with the derivative of the country’s borrowing, and there is no way of knowing whether that component of GDP is 'real' or just economic froth that will disappear when the borrowing turns down.

In which case, you would be better to say that “GDP over the past 20 years involves economic activity increasingly financed by private debt.”

Also, many new houses were built in the bubble years. Do you really deny that the UK’s stock of real housing assets has not been increased by all this building? That even if some of the owners default on their mortgages other people can buy them and live in them? Why are these new houses not a “real” part of GDP?

and that once the borrowing stops, the true size of the economy

I have just demonstrated in a new appendix above that adjusted for imports the US economy is not that much smaller than its present size. Excessive private debt can be reduced under Keynesian stimulus, without wrecking the economy.

So yes, 'austerity' will reduce GDP; it is a statement of the obvious.

It will cause devastating debt deflation which will then destroy productive and profitable sectors of the UK that do NOT rely on debt-fuelled consumption. This is what happened in the Great Depression. Are you really an advocate of the “liquidationist” solution to excessive debt?Proper deleveraging and reduction of private debt can be done without liquidating the rest of the economy.

Do you really deny that the UK’s stock of real housing assets has not been increased by all this building? That even if some of the owners default on their mortgages other people can buy them and live in them? Why are these new houses not a “real” part of GDP?

I think that is a really interesting topic. You are saying that houses are part of "national economic output".

To most people, 'bricks and mortar' are the most solid asset they can think of, which is presumably why you mention houses, not, say, cars or speedboats or flat TVs or holidays or granite kitchen surfaces or iPhones or all the other things that people have spent much of their borrowed money on. And yet, I would have to say that I don't see our housing stock as a particularly valid component of GDP. Our new stock of plasterboard mansions are static; and due to mal-investment possibly built in locations that bear no relation to where the country's most productive industries are located. They don't seem much use to, say, a person in China. That person in China doesn't care if we each have our own palace made of gold, or whether extended families of six live in single rooms (rather like families in China) as it has no bearing on 'national output' - which is all he is interested in.

And yet, I would have to say that I don't see our housing stock as a particularly valid component of GDP.

Newly constructed houses have always been a part of GDP: they are real assets, adding to the stock of real wealth in the community (as opposed to phantom paper wealth).

Our new stock of plasterboard mansions are static; and due to mal-investment possibly built in locations that bear no relation to where the country's most productive industries are located

Why on earth would they all need to be near "where the country's most productive industries are located"? Pensioners and retirees live in out-of-the-way places, like the country and small towns. People who want holiday houses like places away from cities or industrial areas.

But we are discussing whether the conventional measure of GDP is a meaningful indicator or not. What I was trying to say was that I don't see them as a relevant part of the national 'product', or 'output', whether they have always been included or not.

they are real assets, adding to the stock of real wealth in the community (as opposed to phantom paper wealth).

Yes, but to the outside world they are irrelevant. If I were an outside investor trying to decide whether to place my money in country A or country B, the fact that the residents of country A had huge houses with jacuzzis (another real asset) would make absolutely no difference whatsoever. The country could still produce the same 'output' (in a real sense) with many fewer houses than it has now. If the country decided to sell its 'assets' collectively, the true value of a house in an economy such as the UK would be revealed.

Pensioners and retirees live in out-of-the-way places, like the country and small towns.

So pensioners and retirees are contributors to 'national economic output'?

I can think of many UK national assets that would count in a hyper-competitive world, but a large stock of plasterboard flats isn't one of them. If you were a foreign investor, what would mark the UK out as a 'good prospect'?

What I was trying to say was that I don't see them as a relevant part of the national 'product', or 'output'

Given that UK real assets can be bought by foreigners and exchanged for foreign currency (remember that foreign investors buy financial assets or real assets), why not?

Yes, but to the outside world they are irrelevant

They are not "irrelevant."The UK can obtain US dollars (foreign exchange) by selling its real assets to foreigners.Foreign investors buy (1) financial assets or (2) real assets (residential or commercial property).Money is a claim on (1) output, (2) assets (real or financial) or (3) foreign exchange.Please see my post on money:

The UK can obtain US dollars (foreign exchange) by selling its real assets to foreigners.

At the very start of the financial crisis I remember Ruth Lea on Newsnight saying that everything was OK because the sum value of all the houses in the UK was higher than the national debt or some such. In other words she thought that asset bubble values were 'real'. But you don't, surely?

Yes, a house is an asset that represents some share of past national income and possibly, therefore, national output (past, or future if we're lucky). But what it cost to buy may not be anything like what it can be sold for. It may be worth a few quid to a foreign buyer or it may stand empty for years in a riot-damaged street and be sold eventually for £1. Surely the value of assets such as houses is neither here nor there when it comes to competing with the rest of the world. I can't imagine the Chinese government spending a nanosecond factoring in various nations' stocks of houses into their battle plans; they have no bearing on their rivals' potential competitiveness.

But this is a digression, surely? The question is whether a country's GDP today represents its achievable GDP tomorrow. If not, then it is "meaningless" for many purposes.

If the only way to maintain GDP is to flog off 'assets' to foreigners then it is not sustainable; 'the family silver' can only last for so long. Britain has a lot of family silver accumulated from long ago in the Industrial Revolution and the Empire, but its GDP has been swelled for years by the selling off of this. There is only so much of it. The same goes for one-off windfalls such as North Sea oil and the post-war baby boom. As these run out, our GDP will shrink drastically.

It strikes me that the technical definition of GDP assumes implicitly at every stage 'all things being equal' when, in fact, they are not.

In other words she thought that asset bubble values were 'real'. But you don't, surely

Nope, but if you look above I say quite clearly that houses themselves are real wealth as opposed to phantom paper wealth. If house prices fall steeply, foreigners can still buy them. Along with its financial assets, the UK can sell houses to obtain a capital account surplus.

Surely the value of assets such as houses is neither here nor there when it comes to competing with the rest of the world

Correct, but then I never said any such thing.My point is that new houses add to real wealth: there are a stock of wealth mainly for UK residents.

The question is whether a country's GDP today represents its achievable GDP tomorrow. If not, then it is "meaningless" for many purposes.

As I have said above, GDP measures fundamental things like the trade balance, and capital investment. Do you really think the trade balance is "meaningless"?

If the only way to maintain GDP is to flog off 'assets' to foreigners then it is not sustainable;

Selling assets to foreigners has nothing at all to do with GDP. A change in net foreign ownership of UK domestic assets is measured in the capital account.Also, since UK residents own a huge amount of foreign assets themselves, the UK mostly gets a positive investment return on its ownership of foreign assets (this is called net “foreign factor income”). As you can see here (in the table at the bottom under “Net Investment Income”), the UK earns a lot of money in investment returns from overseas:http://tutor2u.net/economics/revision-notes/as-macro-balance-of-payments.html

E.g., £23 billion in 2002, and £29 billion in 2005.

Britain has a lot of family silver accumulated from long ago in the Industrial Revolution and the Empire, but its GDP has been swelled for years by the selling off of this

GDP is not “swelled” by selling financial assets to foreigners, because GDP doesn’t include purchasing of financial assets. Construction of new housing is included in the investment component of GDP, but that is virtually all by UK residents who have new real assets as a result.

You also forget that the UK owns a lot of overseas assets – and gets a return larger than the return foreigners get on owning UK assets. So the fact that money is being drained overseas to foreigners (from their ownership of UK assets) is not a problem.The UK earns more than it loses in investment income from overseas.

GDP may not include certain financial transactions directly, but cash is made available to, or removed from, the economy by them, heavily influencing GDP in the short term (months, years, decades).

Over the long term (and we may be talking centuries) the effect is theoretically neutral.

By regarding instantaneous GDP as an objective measure of the true size of an economy we produce disastrous bubbles, regardless of the theoretical perfection of its definition. I am amazed that you don't acknowledge that.

GDP may not include certain financial transactions directly, but cash is made available to, or removed from, the economy by them, heavily influencing GDP in the short term

Much of the money obtained from selling assets just gets recycled back into other assets (financial or real), so your claim that it heavily influences GDP does not follow. If a foreigner brings in foreign exchange (then converts it to pounds), buys an asset and gives you the money and you spend it on goods or service, this is real money - it is real income backed up by foreign exchange increasing the UK’s capital account surplus.

By regarding instantaneous GDP as an objective measure of the true size of an economy

I have no idea why you describe GDP as “instantaneous.” GDP measures economic activity over a year after that activity. GDP is thus a measure of activity post facto (“after the fact”).

we produce disastrous bubbles, regardless of the theoretical perfection of its definition. I am amazed that you don't acknowledge that.

As I said, asset bubbles in financial assets are not part of GDP. The act of measuring GDP does not “produce” bubbles.

I don’t “acknowledge” this idea because it is totally wrong.

GDP has been exaggerated by excessive private debt, but that does not mean the measure is “meaningless.”

Moreover, UK house prices peaked in August 2007 and have been on whole falling since then (despite the recent rise which is small relative to the drop). So, if anything, you are actually forced to concede that GDP has become more meaningful because of this.

1)Could you describe the blow comment regarding the results of AUSTERITY in a little more depth and possible add some examples? Much appreciated.

2)And do you have a personal view as to why it appears all of the Austrian School fails to understand this issue

"It will cause devastating debt deflation which will then destroy productive and profitable sectors of the UK that do NOT rely on debt-fuelled consumption. This is what happened in the Great Depression. Are you really an advocate of the “liquidationist” solution to excessive debt?Proper deleveraging and reduction of private debt can be done without liquidating the rest of the economy."

First allow me to distance myself from some other posters on this thread.

While I am very critical of the notion of GDP, I agree it is far from meaningless.

As I see it (and I am only rehashing opinions by Arrow, Sen and Stiglitz, with some personal notions) GDP has been used as the main and practically the only benchmark for socio-economic improvement.

In this context, used by itself, without any consideration to distributional issues (among others, like the environment), GDP can be misleading.

In fact, if I remember well, Kuznets (I think that's the correct spelling) himself warned against a more general use of the notion of GDP.

Going further back in time (I have being reading some history of economic thought lately!) Adam Smith himself considered that the mere size or quantum of the national output by itself, without regard to the effort made to produce it, was not a good index of improvement in living conditions.

Another criticism I find appropriate is that GDP underestimates the contribution of public sector, volunteer work, housekeeping and other valuable activities, which contribute to our wellbeing, but that are difficult to asses in dollar terms.